Feeling Sentimental in 2016

Well, Wall Street kicked off 2016 with its worst start to a year ever, spurred by worries about China, oil and geopolitical tensions. Global markets are currently down -6.1% year to date[i], and the bearish punditry is in overdrive. One outlet says to “sell (mostly) everything.” Another urges investors to brace for a 75% drop. (Others opt for a less hyperbolic “the bull market is dead.”) All are based on a litany of long-running, widely discussed false fears (you can see our take here, here, here, here, here, here, here and here). Absent any new evidence of an unseen negative huge enough to knock trillions off global GDP, we believe the bull market should continue, and investors who hang on and ride out the volatility can enjoy a decent year. Despite the sensationalist claims otherwise, economic and political drivers still point positively, and sentiment lags reality. That’s a fairly typical bull market backdrop.

Volatility is uncomfortable, and when accompanied by loud, bearish headlines, it becomes even more difficult to endure emotionally. But sharp swings are normal, both up and down, whether they occur in January, April or August. Just as we wouldn’t encourage anyone to radically shift their outlook because stocks gained 6% in a week, folks shouldn’t turn on a dime when stocks fall that far that quickly. This is a time to take a deep breath, survey the evidence, and make thoughtful, measured decisions. Warren Buffett famously says the time to be greedy is when others are fearful, and the time to be fearful is when others are greedy. Widespread bearish forecasts aren’t reason enough to be bearish, as they often reflect mass sentiment more than market fundamentals. This seems to be the case with the doom-and-gloom prognostications hogging this week’s headlines, illustrating just how skeptical the world is right now. Counter-intuitive as this seems, that is a reason to be bullish.

The current big fear centers on the possibility of a recession striking the global economy—perhaps as soon as this year. Some see China as the catalyst for a global economic downturn, with the long-feared “hard landing” finally materializing. Never mind these fears have reigned for almost half a decade, and nothing in recent economic data suggests anything but a continuation of China’s slowing growth trend—part of the country’s transition from heavy industry-led growth to services and consumption. Others cite the risk of “deflation,” the end of allegedly easy Fed policy, and even low oil prices as huge economic negatives—all fears that actual data have easily debunked. (As have we—here, here and here.) Not just over the past several months, but repeatedly throughout history.

But when skepticism is so widespread, it is all too easy for most to overlook reality—especially when facts are buried or omitted for the sake of running a splashy, eyeball-grabbing narrative. Unfortunately, in many cases, click-baiting trumps reason. The coverage of this year’s volatility underscores this. Global stocks are down mid-single digits for the year, and -10% off last year’s all-time highs—bull market pullbacks are regularly this big (or bigger). Yes, it’s a sharp drop and an unpleasant start to the year. But some folks have characterized this start as a “crash”—which strikes us as a wildly premature use of the term. Call us word sticklers[ii], but a -6% drop over seven trading sessions doesn’t constitute a crash. It’s part of a correction, as similar-sized six-day moves in 2010 and 2011 were. Real crashes happened in 1929 and 1987. The dark days of September and October 2008 qualify as well. Powerful, sudden market moves driven by negative surprises. Considering how frequently “Chinese hard landing” fears (or falling oil prices, geopolitics, etc.) have dominated headlines, they seem to lack much surprise power to roil stocks on anything approaching “crash” scale. Nor is present volatility fundamentally driven. Fear is the culprit, in our view.

At times like this, we encourage investors to turn down the volume on sensationalism and ask: What might the bears be ignoring? In our view, they’re ignoring some pretty positive economic and political drivers. Manufacturing is struggling, but service sectors are making up the difference, and winners from the commodity downturn outnumber the losers. Meanwhile, continued gridlock throughout the US and much of Europe keeps legislative risk low. Sentiment hasn’t really caught on to either, creating a bullish gap between expectations and reality. Add in the fact that short-term pullbacks tend to end as suddenly as they begin, and we see no reason why stocks can’t overcome their rocky start and have a fine year.

However, the magnitude of returns will depend on sentiment’s evolution—tough to handicap, considering how fickle emotions can be. In bull market cycles, sentiment usually progresses from pessimism to skepticism, optimism and then euphoria at the peak as investors gain confidence. If sentiment finally lurches into optimism, that could drive returns higher, bringing the reacceleration that often accompanies maturing bull markets. Often, surging investor confidence accompanies gangbusters returns late in a bull as investors, many who finally take notice of a rising market and fear missing out, start bidding up future earnings. However, it is hard to get meaningful P/E multiple expansion—also normal maturing bull markets—without warming sentiment. It is possible skepticism dominates again in 2016 and weighs on return magnitude, leading instead to just an ok year and perhaps a longer, slower grind through the bull’s final phases.

Sentiment has progressed glacially during this bull, with skepticism lingering for an unusually long time. Though we’re almost seven years into it, investors remain scarred by the Global Financial Crisis and fear a repeat lurks around every corner. Misperceived narratives about quantitative easing (QE) and other factors don’t help. If you believe the Fed was the only reason stocks rose since 2009, it’s hard to envision the bull continuing without Fed support. Even though data (flat yield curve during QE, faster loan growth once it ended, and no history of the first rate hike in a tightening cycle causing a bear market) strongly prove that narrative false and should give folks more confidence. Persistent upside-down views like these increase uncertainty, which fuels investor skepticism—it is difficult to get excited about a cloudy future. This joylessness might mean a longer, slower bull, keeping annual returns below bull market averages, though it may also make this history’s longest bull market in duration. Only time will tell. It’s even possible sentiment never reaches true euphoria in this cycle, with complacency instead marking this peak. In both cases, investors overlook material negatives, with expectations out of line with reality. Complacent investors are just a little less drunk on past returns than euphoric investors.

Regardless of magnitude, though, we think this is a year to own stocks. Don’t let volatility fool you—the backdrop looks good. The global economy is growing, its strength underappreciated. It’s not just the US, either. The much-maligned eurozone has grown for 10 straight quarters, largely offsetting China’s slowdown. And speaking of China, the world’s second-largest economy is still expanding at around 6%-7% annually—contributing about as much to global output as it did during its double-digit growth days because it’s expanding from a larger base. And forward-looking indicators like The Conference Board’s Leading Economic Index (LEI) for both the US and eurozone are in long uptrends—a big counterpoint against recession fears. Politically, developed countries have gridlocked governments, decreasing the likelihood big, sweeping, uncertainty-inducing legislation passes. The US also tends to outperform during Presidential election years, and though there are many variables to be decided in the 2016 race, bullish gridlock overall persists—as it does in the UK and across Europe. So even if some negative volatility persists in the short term, we expect stocks to keep climbing in 2016.